2018 Retrospective: Fitch Solutions Key Themes For Europe

In this article, we at Fitch Solutions take a look at the key themes we set out for Europe at the beginning of 2018 (see 'Key Themes For Europe in 2018', December 5 2017), highlighting instances in which our expectations were well founded as well as instances in which developments caught us by surprise.

Progress on divorce deal and extension of negotiation periods. But protracted negotiations will act as cautionary tale to any other countries thinking of leaving the EU.

3. Russia & CIS - Picking Up Pace Of Reform

Russia - Window of Opportunity of Reform After Election

Somewhat

Rapidly rising oil prices have reduced impetus for economic diversification, while Western sanctions will make the Russian economy even more closed off.

Central Asia Opening Up, Uzbekistan and Kazakhstan To Outperform

Yes

Growth has been strong, and reform impetus remains steady in the region.

Source: Fitch Solutions

Theme 1 - Growth To Cool

With few exceptions, we forecast real GDP growth in European countries to slow in 2018 relative to 2017. While we expect economic activity to remain healthy and, in many cases, still above potential as output gaps close, we also believe expectations are becoming overly bullish for the eurozone in particular due to the ongoing strength of economic data in H217. This raises the potential for growth to disappoint consensus expectations in 2018.

Eurozone - Curb Your Enthusiasm:

Description: "Our core view is that we are nearing a cyclical peak and that growth rates will plateau, and will begin to ease, as we progress through 2018".

Key Developments: This view has played very well, with growth decisively slowing from a peak in H217. We forecast real GDP growth to come in at 2.0% in 2018. This forecast was down from 2.4% growth registered in 2017 and well below 2.4% Bloomberg consensus estimates for the year. Since then, coincident and leading indicators have deteriorated, as the external trading backdrop became less accommodating and labour market gains slowed. This has fed through into decelerating GDP releases in the first three quarters of the year (see chart below), and Bloomberg consensus estimates moving down towards our 2.0% GDP growth estimate for 2018.

Eurozone Growth Slowdown View Plays Out

Eurozone - Real GDP, % chg y-o-y

Source: Eurostat, Fitch Solutions

UK Continues Underperforming Major Economies:

Description: "We forecast real GDP growth to slow further in 2018...in light of the massive uncertainty facing UK businesses in light of Brexit".

Key Developments: This view has played out as we expected. UK real GDP growth has averaged just 1.3% year-on-year (y-o-y) in the first three quarters of 2018 (see chart below), down from a 1.8% figure in 2017 and remaining below comparable major economies. Ongoing Brexit uncertainty, combined with sluggish real wage growth, has underpinned the downturn (see 'Quick View: UK Retail Sales Data Points To Ongoing Loss Of Growth Momentum', November 16). We maintain our forecasts for real GDP growth to come in at 1.4% in 2018 and 1.5% in 2019, down from 1.8% in 2017 (see ‘UK Growth Remains Sluggish’, August 10).

Brexit Uncertainty Underpins Continued UK Underperformance

Real GDP, % chg y-o-y

Source: National Sources, Fitch Solutions

CEE Goldilocks Period Coming To An End:

Description: "EU member states in the Central and Eastern European (CEE) region were the growth outperformers in 2017, with Poland, Romania and the Czech Republic particularly strong...However, conditions will become more challenging in 2018. Inflationary pressures are building, which will necessitate tighter monetary policy."

Key Developments: This view has partially played out, with overheating risks growing amidst elevated inflation and weak regional currencies. That said, growth has held up much better than we expected (see chart below). Q318 real GDP in particular came in stronger than anticipated in CEE, and leading indicators suggest this is the result of domestic demand somewhat offsetting the ongoing slowdown in external demand (see 'Q318 Shows Strong Domestic Resilience In The CEE', November 15). Coincident and leading indicators point towards further losses in momentum across the board, yet the region demonstrated much more resilience despite weaker external demand, with growth in key trade partners such as Germany losing momentum. Going forward, we believe that 2019 will prove to be more challenging for the region, as labour market tightness and rising inflation results in decisive tightening in regional monetary policy.

CE Growth Slowed Less Than We Expected

Real GDP, % chg y-o-y

Source: National Sources, Fitch Solutions

Turkey - Slowdown Inevitable, Break With West Accelerates:

Description: "The Turkish economy in 2017 has been turbo charged by a combination of fiscal stimulus, relatively loose monetary policy, and robust external demand. However, overheating is evident in inflation readings… A slowdown is inevitable in 2018 as policies tighten and capital inflows slow. The latter trend will be exacerbated by Turkey's ongoing re-orientation away from the West.”

Key Developments: This view has played out well. The collapse in the Turkish lira in Q318, triggered by a diplomatic spat with the US over the imprisonment of US pastor Andrew Brunson, led to a substantial lira collapse (see chart below). The currency collapse has exacerbated existing external imbalances, namely the large stock of corporate debt denominated in FX. Tighter monetary policy and higher inflation is now denting consumer spending. While Q318 GDP data has not yet been released, the print will likely show a substantial slowdown when its released (see 'Turkey Headed For Recession, With Bearish Scenario Increasingly Likely', September 21). We forecast real GDP growth to come in at 3.6% in 2018, from a 7.4% outturn in 2017. We are forecasting a recession of 1.9% in 2019.

Lira Collapse Dampens Economic Outlook

Exchange Rate, TRY/USD

Source: Bloomberg, Fitch Solutions

Theme 2 - Inflection Point For EU

For better or worse, 2018 will be pivotal for the EU, and we expect to have much greater clarity on the future of the bloc based on how key events and fault lines unfold over the course of the year. While Germany eventually renewed its Christian Democratic Union (CDU) - Social Democratic Union (CD) coalition, Chancellor Angela Merkel's Mandate was weakened significantly. In early June, the eurozone periphery plunged into a political crisis with the formation of a populist administration in Italy followed the next day by the collapse of the People's Party (PP) minority government in Spain. These issues, alongside ongoing Brexit negotiations and increased disputes with CEE countries, imply that political risk will remain a key theme in Europe for the next few years.

Macron's Reform Agenda to Gain Traction, But Fall Short In Key Areas:

Description: "The election of Emmanuel Macron as French President in May 2017 ushered in a strongly pro-EU and integrationist leader at the core of the bloc, and momentum appears to be building towards fast-tracking reform initiatives...Ultimately, however, we expect red lines to remain in areas such as fiscal transfers, supranational eurozone debt securities, and common deposit insurance. Without such reforms, underlying systemic risks will remain prominent in the eurozone, and will once again become apparent during the next economic downturn".

Key Developments: This view has somewhat played out. While Macron's 2017 election win was followed by a new impetus to implement reforms aimed at improving France's competitiveness profile and labour market flexibility, progress has slowed amidst declining support for the president and increased strike action (see 'France's Domestic Policy Agenda A Risk To EU-Reform Plans', October 2). Indeed, in November strike action crippled the French motorway system, in another highly disruptive show of anger at Macron's policies. On the eurozone reform front, Macron has made less progress than he would have hoped. The weakness of German Chancellor Angela Merkel and rising eurosceptic and populist political forces means his calls for closer eurozone integration are likely to go unanswered.

Eurozone Not Ready For Much Tighter Monetary Policy:

Description: "Our forecasts for the European Central Bank (ECB) are more dovish than market-implied consensus - we expect asset purchases to continue through all of 2018 and for the first rate to come only in 2020. This reflects our view that eurozone inflation will remain subdued, growth rates will ease in 2018, and that with fiscal policy remaining tight and the reform agenda falling short in key areas, monetary policy will continue to do a lot of the heavy lifting in terms of supporting growth".

Key Developments: This view has somewhat played out. The ECB has continued net asset purchases throughout 2018, and confirmed that they will end at the end of the year. That said, an acceleration in headline inflation has led to a slightly more hawkish tone from the ECB in recent meetings (see chart below). We now expect the first rate hike to come in H219, rather than 2020. Even though core inflation remains much weaker than headline readings, the ECB looks set to press ahead with its plan to gradually tighten policy in the coming quarters (see 'ECB Has Few Options But To Gradually Tighten', September 17).

Core Inflation Still Lagging Headline

Eurozone - HICP, % chg y-o-y

Source: Eurostat, Fitch Solutions

Italian Elections To Reignite Political Risk:

Description: "The Italian election will serve as a reminder that the forces of populism and euroscepticism are still a pertinent threat to the stability of the EU...It is easy to envision a scenario which rattles financial market confidence, reignites broader fears over the stability of the bloc, and reinforces the ECB's role as a backstop of eurozone sovereigns. This could take several forms, including the anti-establishment 5-Star Movement (M5S) winning the largest vote share, or a right-wing alliance including the far-right Northern League (LN) coming to power with a eurosceptic platform."

Key Developments: This view played out as we expected. The M5S and LN coalition was formed in June 2018, after nearly three months of negotiations. A pledge to abandon fiscal consolidation plans has led to a large rise in Italian bond yield spreads over comparable German bunds (see 'Quick View: Italian Budget Woes To Underpin Bond Yield Volatility', October 4). Coalition plans to increase the budget deficit to 2.4% of GDP in 2019, from 2.3% in 2017, has led to an acrimonious dispute with the EU which at the time of writing was still playing out. Against this uncertain backdrop, Italian GDP growth has also slowed materially in 2018 (see 'Quick View: Italian Growth Stagnation Highlights Mounting Risks', October 30).

Greek Bailout To End, Negotiations To Offer Insight Into Future Of EU Institutions:

Description: "Greece will successfully conclude its bailout programme when it expires in August 2018, but we also believe that the public debt load remains unsustainable and some form of official assistance or credit line will be necessary beyond 2018."

Key Developments: This view has somewhat played out. Greece’s bailout programme cycle may have officially ended on August 20 2018, but did not require an extended credit line as we expected it would. That said, Greece is not completely out of the woods. It is still tied to a number of reform and budgetary commitments over the coming decade. As part of the agreement, Greece will receive income from the Securities Markets Programme (SMP) and the Agreement on Net Financial Assets (ANFA) and lower interest rate payments up to 2022 if it implements agreed reforms (see 'Greece Post-Bailout: Economy Poses Greatest Risk To Political Future', August 30). Any deviation from the agreed programme, in our view, would likely lead to a rise in perceptions of credit risk and financing costs in financial markets.

Description: "The populist governments of Poland and Hungary have come under fire from the EU over alleged infringements of democratic norms and the rule of law...The EU's options for taking punitive action are limited in the near term, although the potential for a less generous allocation of structural funding in the next 2021-2027 budget remains one potent option.

Key Developments: It is too early to say whether rising nationalism or populism is encouraging a move towards a 'two-speed Europe'. What is clear, however, is that the tide of nationalism continues to rise. This was reflected by the re-election of Hungarian Prime Minister Victor Orban in April (see 'Orban Secures Supermajority, Heightening Risks', April 9) and the strong performance of the Slovenian Democratic Party (SDP) in the country's June elections (see 'Fragmented Parliament A Concern For Political Stability', June 5). Since these elections, however, the EU has started to take a tougher line against nationalist parties across the region. The EU has threatened to divert Structural Funds to the eurozone periphery, if government's in CEE fail to uphold EU rules on judicial independence and on migrant resettlement. While nationalistic rhetoric will persist, we expect CEE governments to broadly step in line in order not to jeopardise funding in the 2021-2027 Structural Funding round.

Brexit A Model To Emulate Or Avoid?

Description: "A key question following the June 2016 Brexit referendum was whether it would set a precedent and be a catalyst for a further breakup of the bloc. For now it appears that the UK's experience is making it less likely that another country would want to pursue a similar course."

Key Developments: The UK's torturous negotiations with the EU are unlikely to compel other members to follow the same course. Indeed, opinion polls imply that Brexit has materially boosted support for remaining in the EU across the rest of the bloc (see 'Weathering The Storm: Reaons For EU Optimism', August 29). The disunity of the UK's governing Conservative party, and across the wider UK, has looked chaotic compared to the unified front adopted by the remaining 27 EU members. We believe there is still a long way to go in Brexit negotiations, but the likely outcome is that the UK will exit in a 'soft Brexit' arrangement. This will offer less benefits than remaining in the EU, with the UK also losing a seat at the decision making table with regards to the rules it will still have to adhere to (see 'No Business Other Than Brexit', September 28). We doubt many economies will be rushing to emulate the new position of the UK.

Theme 3 - Russia & CIS - Picking Up Pace of Reform

Economic reform will play a prominent role in Russia and the CIS region over the coming year, though there is unlikely to be any moves away from authoritarian systems of governance. The embrace of structural changes will help set certain countries apart from others, particularly in Central Asia.

Russia - Window of Opportunity for Reform After Election

Description: "Following the March 2018 presidential election, which Vladimir Putin is assured to win, we see scope for the implementation of unpopular fiscal reform needed to bolster the public finances over the long term....That said, we do not expect a fundamental change in the overbearing role of the state in the economy, keeping growth potential low amidst lower commodity prices."

Key Developments: Following the March 2018 presidential election which gave Vladimir Putin an overwhelming victory, the Russian government pushed forward a very unpopular pension reform which from 2019 will gradually raise the retirement age from 55 years to 60 years for women and from 60 to 65 for men. The latter has dented Putin’s and the government’s popularity. Within its fiscal framework, the Russian government is also pushing forward a series of tax changes, to keep financing levels stable against stagnating economic growth. These include a VAT tax increase from 18.0% to 20.0% starting in January 2019 ,as well as an overhaul of taxation in its oil and gas sector. Overall, reform efforts are focused on sheltering the economy from potential external shocks against the risk of new, tighter US sanctions. Instead, the implementation of much needed reforms to bolster the country’s economic outlook - such as increasing protection for property rights, decreasing the state’s role in the economy, modernising the judicial system – continues to be delayed, and we see limited scope for improvements in this direction under the current political regime.

Decoupling From Oil?

Russia - Exchange Rate, RUB/USD (RHS) and Brent, USD/bbl (LHS)

Source: Bloomberg, Fitch Solutions

Central Asia Opening Up, Uzbekistan and Kazakhstan To Outperform:

Description: “Some Central Asia states in 2017 took steps towards opening up their economies to greater international investment, a trend we expect to continue in 2018.”

Key Developments: Our view that some Central Asian states, particularly Uzbekistan and Kazakhstan, are opening up to greater international investment has played out (see Special Report: 'Central Asia: The Next Emerging Markets', August 1). Uzbekistan was among the top-10 countries that showed the most notable improvement on the World Bank's '2018 Ease of Doing Business Index'. The country’s distance to frontier score, which benchmarks economies with respect to regulatory best practice, improved by 4.5, making the country the regional leader on the count of reforms in all of Europe and Central Asia.

Kazakhstan also made notable improvements in the spheres of registering property, protecting minority investors and enforcing contracts, improving the country’s overall ranking on the index from 36 in 2017 to 28 out of 190 in 2018. As anticipated, these regulatory improvements have also led to an uptick in foreign direct investment inflows. Gross foreign direct investment inflows into Kazakhstan rose by 15.4% y-o-y in H118, and we expect investment to remain buoyant as the country continues to modernise and diversify its hydrocarbon dependent economy.